The real questions behind the politics of tax and spend

Warning: this is a longer read for those interested in achieving a deeper understanding of political choices, especially here in Britain. I write it to release some my internal tensions after a tough few weeks helping to organise my party's general election campaign, while tackling questions posed by tightening school budgets.

The politics of tax and spend is close to the heart of Britain's general election campaign. And yet the quality of economic commentary is very shallow. Here is my attempt at something deeper.

Running government finances is not like running a household budget. The primary constraint on a household budget is money, which can be treated as a fixed resource, and can be stored for use at a future date (so long as inflation is not a major factor). But looking at an economy as a whole, money is just an economic tool, a means to an end. Hoarding it is pointless. Money is tactics, not strategy.

So to look at matters strategically we need to take money out of the picture, and ask what it is that we are trying to achieve. A higher level of public services? More private consumption? More investment for the future? All of these things are constrained by real resources. By which we mainly mean people. If we want to increase the level of consumption or investment, more people need to be put to work, or the same number of people need to work harder or more productively. The latter may also be a function of capital assets, but capital assets are created by people working in earlier periods and forgoing consumption.

So, if you want to expand public services, the question arises as to where the extra resources are to come from. If you are hiring 10,000 extra policemen, those individuals may be doing nothing now, in which case the economy as whole expands costlessly. Or they may be doing important jobs elsewhere, in which case the recruitment will potentially reduce the production levels of their previous employers. And what if you simply raise the level of pay for the same work? Or increase the level of a cash benefit. That is a way of raising the levels of consumption for those targeted individuals. Who is to produce those extra things they are to consume?

And so we come to a central question of fact, which is discussed surprising little. The left claim that there is plenty of spare capacity in the economy, so if we expand the consumption of the disadvantaged, or the reach of public services, the economy as a whole will respond by utilising those spare resources, and nobody is disadvantaged. This idea goes by the term "Keynesianism". It is more likely to be true in a recession than at the height of a boom. The right thinks that spare capacity is not so easily manipulated, and such expansion will usually come at the cost of private consumption, whether that is intended or not. And in Britain, when employment is at record levels, and we are still net importers of goods, this is not so easily dismissed. Some on the left counter with the hope that any reduced consumption will be by the rich, of luxury goods.

But many more thoughtful observers think that there is still spare capacity in the economy. They point to low levels of pay and productivity in many places. If there was more pressure from the demand side of the economy, then private sector produces might sharpen up and become more productive. And if the extra public resources were directed well, into investment, then that will help expand future capacity too. The likelihood of these outcomes depends a lot on the tactics.

But before considering the tactics - the details of taxation and monetary policy - we need to reflect that modern, developed economies are quite open. We can import resources from abroad. And we can import workers. For certain advantaged economies, like the USA, a high level of net imports is completely sustainable. And there are economies out there (Germany, for example) that are happy to be net exporters, for their own tactical reasons. But for others a prolonged period of net imports, especially if not used to create productive assets, can lead to a financial crisis and the seizing up of the economy. Where the UK stands between these two poles really is unclear; the country has been a net importer for most of recent history, and financially stable for most of that period too. But there will be a level of net imports that is unsustainable; and a financial crisis can take many years to build, as we found in 2008.

It is worth touching on the issue of immigration. What if the extra workers needed for expanded public services could themselves be imported, either directly or to substitute for home recruits? These workers will create demands of their own, but it is one way of squaring the circle. Indeed in the mid noughties, when the Labour government undertook a significant expansion of the public sector, this was one of the ways they were able to sustain it, using workers from the new entrants to the EU from central and eastern Europe. That Labour leaders are now saying that this influx was a serious mistake is a piece of hypocrisy; they love to take credit for the expansion of public resources at the same time.

It is worth trying to establish these basic rules on strategy - but it is not hard to see the strategy that public leaders converge on, from left and right. It is to expand public services and benefits (such as pensions and hardship relief) while taking up slack in the country's productive capacity, or expanding that capacity through higher productivity. And so we turn to the tactics. If the tactics of expanding the public sector go wrong, there is a more or less disorderly reduction in the levels of consumption by the general public in order to make room.

We need to understand what we mean by this. In the conventional view of economists this about one thing above all: inflation. Most economists like the idea of a little bit of inflation (I don't agree, but because I think inflation erodes trust in public institutions rather than its effect on short-term incentives, the obsession of most economists). But inflation can quickly become unhealthy, so that an increasing amount of effort is placed in managing money rather than valuable production, and it clogs the process of exchange, which is the foundation of a healthy economy. Inflation occurs when demand outstrips supply. Its effect in this context is either to undermine the attempt to expand the public sector, by eroding real wages or the real value of the benefits, or by reducing public consumption as real incomes are reduced. The so-called neo-Keynesian consensus of the 1990s and early 2000s built an entire edifice on this idea - using a targeted rate of inflation as the primary way of determining whether an economy was in balance. The idea still stalks the conventional wisdom.

But that was dealing with yesterday's problem. Neo-Keynesianism was built in response to the 1970s phenomenon of stagflation, when the old-fashioned "Keynesian" model broke down (quotation marks because though Maynard Keynes's fingerprints are on this old conventional wisdom, such a flexible mind would surely have moved on as the facts changed). But what emerged in the 1980s and 1990s was different. It was changed by two things - a shift in the balance of power in the political economy towards employers, and away from employees and unions; and the process of globalisation. Globalisation, we must understand, is a combination of more advanced production and communication technologies, and the opening up of new Asian economies into the global trading system, starting with Japan and moving by way of South Korea and Taiwan to the giants of India and China. This has broken down the previous relationships between demand, supply and price.

First, it has broken the link between prices and pay. It used to be easy to identify a single rate of inflation that, give or take, would apply to both prices and wages. At first this seemed to work in workers' favour. Cheap imports from Asia held price inflation in check, but workers' pay kept ahead. But since the crash in 2008 this has flipped. Rises in prices (often from those same Asian imports) are not reflected in pay levels. It makes no sense to talk of a single level of inflation, and to use consumer price inflation as a lone yardstick of economic health. And the second change is that other ways that excess demand can be satisfied have been made easier. It is easier to import goods and services either directly, by buying from foreign firms, or indirectly by domestic firms outsourcing production. We are still trying to understand what the impacts of these changes are. But excess demand is likely to lead to two things: fat profits by businesses as they are able to increase their prices while holding wages down, and an increasing trade deficit. It is also means that the risks of excessive inflation are much lower, as it quickly feeds into lower real incomes and dampening demand.

At this point we need to think about money. This, too, has changed dramatically, as technology has moved us away from physical currency to a much more flexible system of paying for things. The idea of "money supply" as being a physical thing that needs managing as such is increasingly old-hat - another nail in the coffin of neo-Keynesianism. Instead, policymakers need to think about interest rates, exchange rates and controls of the physical transfer of capital (in this case money balances not required for consumption) within economies (banking controls) and between them (exchange controls). If this goes wrong, people lose confidence in the means of exchange, and the economy rapidly melts down - as we can see happening now in Venezuela. This is what spooked so many governments in 2008 and 2009 when they launched into a series of panicky bail-outs of banks.

And so in this brief overview (that is already much longer than my usual posts) we at last come to where most of the political conversation starts: taxation and public debt. Looked at through the eyes of an economist (money is not a thing in itself, remember) the main purpose of tax is the regulate demand so that we have an orderly economy. Not enough tax, and the financial system becomes unstable, with or without inflation. Too much tax and it is a self-inflicted wound - living standards are lower than they need to be. Tax has other important functions too, of course. It is a means of wealth redistribution (and too skewed a distribution of wealth leads to a poorly functioning economy), and managing incentives. Whether an economy needs more or less tax at any given point depends on a wide variety of factors, of which the size of public spending is only one. This has led to a lot of tension between economists and politicians, especially in the austerity years from 2010. Politicians insist on talking as if public accounts were like household accounts; economists (or many of them) say this is self-harm. Actually a lot of the argument is at cross purposes. What the politicians do, and what they said were different things. Oddly enough, I suspect that politicians were in fact thinking long term, and trying to rebalance the economy, while economists were obsessing about the moment - a reversal of the usual characterisation.

And what of public debt? This again is not all it seems. Many governments, including the US, the UK and most spectacularly, Japan, have asked their central banks to quietly buy up government debt. This acts to in effect cancel it. The world has not ended, as some conservative commentators have suggested it would. What is going on? The central bankers are reacting to an unbalanced financial system. For one reason or another there is too much hoarding of money, by business organisations and rich individuals. This hoarding is sucking demand out of the economy. And it is also creating excess demand for short-term financial instruments. Governments are taking advantage of this by satisfying this excess demand by buying back longer term debt. They hope that in the process they will restore some of the lost demand by encouraging more genuine capital investment, as opposed to a continuing financial merry-go-round. There is little evidence for this working, though.

This makes it an extremely easy time for governments to finance budget deficits and investment - at least tactically. And that is why calls for more public investment at a time of high national debt only outrages conservative politicians and their allies. But the strategic question remains. As real resources are mobilised towards these ends, what will the impact be? There may indeed be spare capacity to be utilised, but that actually be what happens?

To me the key point to arise from this is that managing public finances is a matter of competence and discipline. The left may well be right that in the short term that we can expand the public sector with few real risks, even without raising taxes by much. But that could turn bad very quickly. Do they have the competence to appreciate when that moment arrives, and the discipline to act?

This is where the Labour government of the mid-noughties fell down. They expanded the public sector, while holding, or even cutting, taxes on mainstream income and consumption (as opposed to capital transactions). They secured growth with low inflation (those cheap Asian imports helped a lot), but not based on genuine productivity (supposed advances in productivity were in sectors such as finance where it turned out to be chimerical). Rapid immigration helped sustain this, but it created tensions, especially in working class communities. And they failed to grasp that the extent of the financial boom, which generated a lot of short-term tax revenue, was creating systemic risk. As a result the financial crisis was a rout for the UK, unlike the relative calm of better-managed economies such as Canada or even France.

And yet there is no sign that either wing of the Labour Party has learnt from this. They want to stoke up demand but have no understanding of when enough will be enough. The Conservatives have many faults (and their idea of eliminating the budget deficit is plain nutty), but to my mind they show a greater grasp of the strategic risks, and the need for discipline and competence (as do my own Liberal Democrats, come to that - indeed Vince Cable showed more awareness of the dangers in the mid-noughties than any other leading politician).

But quite apart from party differences, I feel that there is a deeper need to reform the process of governance so that these risks are managed more securely. There is a slo a need to reform the workings of the economy so that extra demand for goods and services does not simply end up in fat profits and foreign jobs. Alas there is little talk from any of the parties of how this is to be done.

8 thoughts on “The real questions behind the politics of tax and spend”

“A higher level of public services? More private consumption? More investment for the future? All of these things are constrained by real resources. By which we mainly mean people.”

Exactly right. I might comment more later but right now I’d just ask where private debt fits into your analysis. You’ve not mentioned that in your otherwise wide ranging discussion. But you need to include it. The 2008 crisis was caused by high levels of private debt. There are no rules in the EZ about how high that can be. So many countries like Greece, Ireland and Spain did well when everyone was borrowing and spending.

The same happened in the UK and USA but when crash hit and the borrowing severely slowed, ( or should that be the borrowing severely slowed so the crash was brought about?) the Government could, to a large extent take up the slack. But the EZ countries couldn’t because were up against the SGP rules.

It strikes me that all that has mattered to Governments (Lab, Con and Lib/Con alike) in the last couple of decades is to shift the borrowing necessary to keep the economy moving, from the public to the private sector. There’s been no attempt to understand why that borrowing needs to happen. There’s starting to be some discussion now but it has taken long enough!

We’ve reached the end of the line for interest rate-ism so when the next crisis hits I’m just wondering what politicians are going to do now that Central Banks can’t lower rates any further?

A fair challenge, as ever from you Peter! The truth is I haven’t fully collected my thoughts on the issue. As reflected in my post, my main concern is threats to financial stability and the payments system, rather than on aggregate demand. Much (most?) lending is associated with financial speculation or engineering of one sort or another, which does not affect aggregate demand directly. For that reason I am very suspicious of aggregated figures. A single piece of “real” debt, like a Californian sub-prime loan before 2007, my be resold multiple times, each time leveraged, and grossing up to many times its original value. Still, private debt clearly has an important role in the management of aggregate demand. And public debt is much less of a threat to financial stability than private debt.

You need to change one of your “publics” to private in your last sentence. I think agree, but I’m not sure.

But I would argue that it is private debt which is the problem at the moment. It is not the borrowing as such which causes the problem it is the changed spending pattern that the lending and borrowing brings.

In pre- credit card days it was normal to “save-up” for the purchase of a large item. The saving has a depressing effect on the economy. Then at the end the money is spent which is a stimulus. But providing not everyone is doing the same thing simultaneously it doesn’t matter. Everything averages out.

Now we have credit facilities there tends to be less of that. So the stimulus is at the start of the process when the lending occurs and the depressing effect comes afterwards when the loan is repaid. This can all occur near simultaneously in the wider population too. When interest rates are lowered everyone tends to do the same thing. So the borrowing and spending doesn’t average out.

For several years we have been in the situation where the effect of private debt has had a significant depressing effect on the economy. So interest rates have been continually lowered to encourage us all to take on even more debt to compensate for having taken on too much debt previously. That’s why interest rates as as close to zero as they possibly can be and why there is nowhere to go next time.

Yes the dynamics have changed. I suspect the critical factor is whether incomes are growing or not. If people expect their income to grow, they will borrow more (and spend it). If incomes are squeezed, high levels of debt exacerbate it. So you would expect private debt to make private spending more volatile. I don’t what evidence there is for this though.

As I understand it this is known as Fisher debt deflation. Minsky had an input with his “Minsky moment”. So the evidence is in the crashes of 1929 and 2008.

Asset prices have risen purely because everyone expected them to rise previously and fuelled by excessive private borrowing. So the “greater fool” theory applies and it is possible to still make money in a rising market even with overvalued prices.

But not the “last fool”. No one knows in advance quite who the last fool will be. But it has to be someone. When it’s his turn the market collapses.

Why is it always this way around? What not “spend and tax” ? Consider the situation where a government is starting off a new currency – for example say Greece decided to have a New Drachma. The ND doesn’t exist. No-one has any. So there wouldn’t be any point in a Greek government issuing tax bills denominted in ND. They’d have to spend them into existence first then issue tax bills.

So logically the spending has to come first then the taxation follows to establish a demand and therefore a value for the currency. That’s the way to understand it too. Otherwise we end up thinking that it’s the taxpayer who creates the currency and not the government.

Certainly “tax and spend” is a conservative formulation. But I think it’s a bit chicken-and-egg. You have described money as vouchers to pay taxes with. So without taxation there is no effective currency. So the government would be paying for services with useless bits of paper? So the Greek government would have to announce a tax regime before it started paying anybody…and then collect it later.

Or, perhaps, alternatively, they could peg a new currency to the euro temporarily, and then later allow it to float. I think that’s what is likely to happen at some point.

The characteristic of a floating currency is that it is effectively a tax voucher, as you say. That’s what gives it its value. There are valid criticisms of the Greek taxation system and a move to a new currency wouldn’t necessarily fix their economic problems if these weren’t addressed.